Introduction
Trusts are commonly used to determine how a person’s assets should be managed and distributed before and after death. Revocable trusts are created during the trustor’s lifetime and can be altered, modified or revoked at any time. As the name suggests, an irrevocable trust cannot be altered upon its creation.
There are many benefits of irrevocable trusts, such as asset protection from future lawsuits and creditors. An irrevocable trust is also protected from long-term care expenses.
Due to their flexibility, a trustor is able to stipulate the terms of how beneficiaries receive their assets, such as having to wait until a certain age. While there are numerous advantages of irrevocable trusts, there are also some downsides.
Inflexibility
Unlike a revocable trust that can be changed at any point during the trustor’s lifetime, an irrevocable trust is highly inflexible. Once assets have been moved into an irrevocable trust, you essentially lose control over them. The only way to amend an irrevocable trust is to acquire permission from all adult beneficiaries.
In some cases, the terms of an irrevocable trust can be altered when the trustee is given authority to make changes or to transfer assets to a separate trust. As this can be a complex move, it is important to have guidance from a skilled probate lawyer.
Loss of Asset Control
When assets are placed into an irrevocable trust, you lose all control over these assets. This means that you can no longer retrieve these assets, even if you experience financial difficulty and want to sell them to raise money. When a trustor signs an irrevocable trust agreement, the trustee named on the document assumes control over all assets.
The trustor is responsible for administering and distributing assets according to the terms set out on the agreement. The trustor is the only person who has the right to make changes to the insurance policy and exercise policy options.
Tax Implications
Irrevocable trusts are considered separate legal entities for tax purposes. If a trust earns more than $600 in income in a single tax year, the trustee must file federal income taxes based on the trust’s tax rate. The trustee will also need to pay any federal or state income taxes due.
Transferring assets to an irrevocable trust may also require the trustor to file a gift tax return with the Internal Revenue Service (IRS) or with the state. If an irrevocable trust is created as part of an estate tax planning strategy, estate taxes may also be impacted.
Three- and Five-Year Rules
Irrevocable trusts come with certain rules that dictate how the trust should be managed in certain situations. The three-year rule on irrevocable trusts states that if you have life insurance in the trust and you pass away within a three-year period, any proceeds are returned to your estate and then become taxable.
Under the five-year rule, if you require Medicaid within a five-year period, you may be responsible for repaying all prior transfers to the trust by covering nursing home expenses. You will only be eligible for Medicaid after repaying all gifted assets.
Complex Trust Terms
The terms of an irrevocable trust can be complex and difficult to understand without the assistance of an experienced probate lawyer. Up to $14,000 can be transferred into the trust each year tax-free. However, to receive these tax benefits the asset must be considered a “present interest gift.” This means that the beneficiary must be able to access part or all of the assets immediately. If a gift does not qualify, it will be subject to a federal gift tax. A trust document should also contain some contingencies to account for the unexpected.
Creating an Irrevocable Trust
While an irrevocable trust has certain downsides, they offer excellent asset protection and can be an effective estate planning tool for aging adults. An irrevocable trust can protect assets from creditors and judgements, remove taxable assets from the estate to take advantage of estate tax exemptions, and prevent the misuse of assets by beneficiaries.
An irrevocable trust also allows parents to gift a home or assets to their children with fewer tax implications and without interfering with any income generated.
Need help creating an irrevocable trust? Reach out to the Arizona estate planning experts at JacksonWhite Law.
Call our Arizona Estate Planning team at (480)467-4325 to discuss your case today.
